Inflation expectations fall below pre-election levels and support T-note prices
U.S. consumer sentiment expected to remain strong
U.S. housing starts expected to remain strong
Inflation expectations fall below pre-election levels and support T-note prices — The 10-year breakeven rate on Thursday fell to a new 7-month low of 1.69%, which was -4 bp below the pre-election level of 1.73% seen on November 7, 2016. The 10-year breakeven rate is the difference between 10-year nominal and TIPS notes and approximates inflation expectations over the next 10 years.
The decline in inflation expectations is due to (1) the recent decline in the CPI and PCE deflator statistics, (2) softer U.S. economic data, including Wednesday’s -0.3% decline in May retail sales, (3) sharply reduced expectations for the Republican growth agenda, (4) tighter Fed policy with the 75 bp rate hike in the past 6 months and the balance sheet reduction plan that will begin later this year, (5) the sharp decline in oil prices, which are near a 7-month low and have failed to see support from the 9-month extension of the production cut agreement, and (6 ) weak overall commodity prices as the Thomson Reuters Continuous Commodity index fell to a new 7-month low on Thursday.
The U.S. May CPI report released earlier this week fell to a 6-month low of +1.9% y/y (from Feb’s 5-year high of +2.7%) and the May core CPI fell to a new 1-3/ 4 year low of +1.7% (from Jan’s 8-1/2 year high of +2.3%). The PCE deflator, the Fed’s preferred inflation measure, was at +1.7% in May and the core PCE deflator was at +1.5%, both comfortably below the Fed’s inflation target of +2.0%.
Inflation expectations in Europe are also falling. The German 10-year breakeven rate on Thursday fell to a new 7-month low of 1.00%. The Eurozone May CPI of +1.4% y/y and core CPI of +0.9% were both well below the ECB’s target of just below +2%.
The recent plunge in inflation expectations has been very positive for Sep T-note prices, which posted a contract high on Wednesday after the weak U.S. retail sales and CPI reports. The 10-year T-note yield on Wednesday posted a 7-month low of 2.10% before rebounding higher to close at 2.16% on Thursday. The current 10-year T-note yield of 2.16% is now only +33 bp higher than the pre-election level of 1.83% even though the Fed since the election has raised interest rates three times by a total of +75 bp. As long as the inflation statistics and oil are pointed lower, and the U.S. economic data remains soft, T-note prices should continue to see an upside trading bias.
U.S. consumer sentiment expected to remain strong — The market consensus is for today’s preliminary-June University of Michigan U.S. consumer sentiment index to show a slight decline of -0.1 points to 97.0, reversing May’s +0.1 point increase to 97.1.
The U.S. consumer sentiment index after the November election soared by +11.3 points to a 13-year high of 98.5 in January but then fell back and was virtually unchanged in April-May. The current index level of 97.1 is only -1.4 points below January’s 13-year high, illustrating that U.S. consumer sentiment remains very strong. Consumer sentiment is being supported by the strong labor market, rising incomes, record highs in the stock market, steadily rising home prices, low gasoline prices, and hopes for personal income tax cuts. Negative factors for consumer sentiment include rising credit stress for sub-prime borrowers and Washington political uncertainty.
Despite the strength in consumer sentiment, U.S. consumers are being stingy with their spending, putting a damper on U.S. GDP growth. This week’s May retail sales report showed a disappointing decline of -0.3% for both the headline and ex-autos series. U.S. retail sales have shown virtually no net growth since February. In Q1, personal spending contributed only +0.44 points to the Q1 GDP report of +1.2%, much less than the average contribution of 2.1 points seen in 2016. The weak Q1 GDP report of +1.2% was mainly attributable to weak consumer spending.
The markets have been expecting Q2 GDP to show a rebound of about +2.4%. The Atlanta Fed’s GDPNow forecast is more optimistic and is forecasting Q2 GDP at +3.2% with a solid 2.21 point contribution from personal spending. However, if consumer spending doesn’t pick up significantly, then Q2 GDP is likely to be disappointing and raise more doubts about whether the Fed will be able to execute its next rate hike by year-end as it currently intends.
U.S. housing starts expected to remain strong — The market consensus is for today’s May housing starts report to show a +3.9% increase to 1.218 million, more than offsetting April’s -2.6% decline to 1.172 million. U.S. housing starts posted a 10-3/4 year high of 1.328 million units in Oct 2016 but more recently in March-April fell by a total of -9.2% to post a 5-month low of 1.172 million units.
Much of the recent weakness in housing starts can be attributed to multi-family starts. Single-family home starts, by contrast, remain relatively strong and in April were up +8.9% y/y at 835,000 units, which was only -4.1% below the 8-3/4 year high of 8710,000 units posted in Oct 2016. U.S. home builder confidence remains strong, as seen by Thursday’s report that the National Association of Home Builder’s confidence index of 67 was only -4 points below March’s 12-year high of 71. U.S. home builder confidence is being supported by strong demand for homes, high new home prices, and tight availability.
U.S. home builder stock prices, in fact, reached new highs this week on the drop in interest rates and mortgage rates. The SPDR S&P Homebuilder ETF this week broke out to a new 1-3/4 year high on Wednesday and is up +14.3% year-to-date.